Based on what I read, Everquest’s original assets had significant exposure to subprime mortgage loans, and the document disclosed it, “a substantial majority of the [asset-backed] CDOs in which we hold equity have invested primarily in [residential mortgage-backed securities] backed by collateral pools of subprime residential mortgages.” Based on my rough estimates, it was as high as 40 percent to 50 percent.
I explained my concerns to Matt in a general way. Among other concerns: (1) money from the IPO would pay down Everquest’s $200 million line of credit to Citigroup; (2) the loan helped Everquest buy some of its assets including CDOs and a CDO-squared from two hedge funds managed by BSAM, namely the Bear Stearns High-Grade Structured Credit Strategies Fund that had been founded in 2003 and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund (“Enhanced Leverage Fund”) launched in August 2006; and (3) the assets appeared to include substantial subprime exposure.
Matt Goldstein posted his story on Business Week’s site later that day. Initially it was called: The Everquest IPO: Buyer Beware, but after protests from Bear Stearns Asset Management, Business Week changed the title to Bear Stearns’ Subprime IPO. I hardly think that pleased Bear Stearns more.
Ralph Cioffi contacted me about the Business Week article. He said that dozens of IPOs like Everquest had been done—mostly offshore so as not to deal with the SEC. According to Ralph, BSAM’s hedge funds and Stone Tower’s private equity funds would own about 70 percent of Everquest stock shares (equity), and they had no plans to sell “a single share at the IPO date.” They planned to use the IPO proceeds to pay down the Citigroup credit line and possibly buy out unaffiliated private equity investors.
I responded that verbal assurances that there are no plans to sell a share at the IPO date are meaningless. Publicly traded shares can be sold anytime. But even if the funds kept their controlling shares, it was not good news. Retail investors would have only a minority interest which would be a disadvantage if they had a dispute with the managers.
Ralph claimed that subprime was “actually a very small percent of Everquest’s assets.” He reasoned that on a market value basis the exposure to subprime was actually negative because Everquest hedged its risk. Technically, Ralph might have been correct—but the registration statement for the Everquest IPO itself suggested otherwise: “The hedges will not cover all of our exposure to [securitizations] backed primarily by subprime mortgage loans.”
It is fine to talk about net exposure (left over after you protect yourself with a hedge), but one usually also discusses the gross exposure (of the assets you originally bought). Hedges cost money, so they can reduce returns.
Ralph Cioffi said CDO equity is “freely traded and easily managed.” I countered that CDO equity may be easy for Ralph to value, but investment banks and forensic departments of accounting firms told me they have trouble doing it. I told him that if this were a CDO private placement, it would have to be sold to sophisticated investors and meet suitability requirements, but since it is in a corporation, it can be issued as an initial public offering (IPO) to the general public. It seemed to be a way around SEC regulations for fixed income securities, and it was not suitable for retail investors in my view.
Ralph said he would talk to his lawyers about changing the IPO’s registration statement to add a line about third party valuations. We seemed to be talking at cross purposes, since the registration statement already said that third party valuation would occur at the time of underwriting. The problem with that was that the assumptions for pricing would be provided by a conflicted manager, and assumptions are critical in determining value. Moreover, on an ongoing basis, one had to rely on a conflicted management’s assumptions for pricing.
Ralph did not seem to want to end the discussion, so I asked him if there was something he wanted me to do. He said it would be great if I issued a comment saying I was quoted “out of context,” that my being quoted in Business Week lent credibility to the article and was not helping me, and that I would be “better served” writing my own commentary. I ignored what I perceived to be a thinly veiled threat. I told him that if he wanted me to write a commentary, I would do a thorough job of raising all of the objections I had just raised with him. Ralph seemed unhappy but my thinking he was a hedge fund manager from Night of the Living Dead was the least of his problems.